By Marc Gunther

(FORTUNE Magazine) –

ABOUT 1,600 MILES UP THE COAST FROM the National Hurricane Center in Miami where meteorologists track tropical storms, researchers at a small company in Portland, Maine, pore over their own data, charts, and historical records to forecast corporate disasters--scandals, bankruptcies, lawsuits, and other threats to shareholder value.

The Corporate Library, which focuses on the performance of boards of directors, has in its short history anticipated a number of storms that others have missed. It sounded early warnings about the troubles that eventually hit Global Crossing, Tyco, Sprint, DPL, and Kmart, among others. Two years before Maurice R. "Hank" Greenberg was forced to resign as CEO of American International Group, it downgraded the insurance giant into its "high risk" category, citing Greenberg's excessive pay and the control he apparently exercised over its board. "We told you so," crowed Ric Marshall, the chief analyst of the Corporate Library, after the AIG scandal broke.

As the wave of corporate scandals unfolded in 2002, three research firms--the Corporate Library, Institutional Shareholder Services (ISS) in Rockville, Md., and Governance Metrics International in New York City--moved aggressively to market governance ratings they had been compiling for years. Today the rating business is growing fast, with institutional investors, money managers, hedge funds, regulators, and insurance companies--particularly those who write directors and officers' (D&O) insurance, which protects board members and executives against shareholder lawsuits--paying as much as $150,000 a year for their services.

On the one hand this is valuable stuff. "I'd dreamed of rating boards from Triple A to junk, like bonds, because boards are a risk factor that no one was paying attention to," says Nell Minow, the editor of the Corporate Library, who started the company in 1999 with longtime corporate critic Robert A.G. Monk. ISS gave low ratings to Adelphia, WorldCom, Xerox, Parmalat, Royal Ahold, and Hollinger before their problems arose. Governance Metrics International gave below-average ratings to Fannie Mae, Freddie Mac, Krispy Kreme, and Interstate Bakeries.

But you also have to wonder just how precise these ratings are. The Corporate Library gives subpar grades of D or F to 162 of the FORTUNE 500 (including such blue chips as Wal-Mart Stores, Exxon Mobil, GE, Chevron, Citigroup, and Time Warner). With that many companies tagged, the odds of picking up one or two cases to brag about are pretty good. An example of just how inexact this science is: ISS actually gave top ratings to AIG, and even raised the company's score in 2004. GE gets top ratings from the other two agencies but an F from the Corporate Library, which takes issue with the size of CEO Jeffrey Immelt's compensation and the board's composition (too many CEOs, for one thing). Because each rating firm uses its own methodology and data sets, results can differ dramatically; all are refining their models. "We all suffer from having a very short history," says Gavin Anderson, CEO of Governance Metrics.

That hasn't stopped the Corporate Library from putting its money where its mouth is: Founders Monk and Minow have seeded two small funds (assets: about $100,000 each) that buy shares of firms with better ratings and short low-rated ones. Its own study found that companies it graded A, B, and C outperformed those graded D and F in each year since its first set of ratings came out in 2002. ISS, meanwhile, has formed a partnership with the FTSE Group to create six investable indexes, each of which eliminates companies with the lowest governance scores. The idea is to match or exceed the broader indexes, with lower risk. Or as the Corporate Library's Marshall puts it: "Not every tropical storm becomes a hurricane. But you ignore the storms at your peril."

Grading the Boards

The Corporate Library says these boards are among the worst, but rating governance is an inexact science. Only Viacom gets low marks from all three outfits.

*A rating of a company's governance relative to the rest of the S&P 500; higher numbers are better.